Changes in Corporate Bonds, Part 2

In the second of a two-part series, Merkel looks at changes in corporate bond analysis.

This column was originally published on RealMoney . It's being republished as a bonus for TheStreet.com readers.

Two changes have taken place in the corporate bond market in recent years. The first change deals with credit default swaps (or CDS), which I discussed in Part 1 . Today, in Part 2, I'll examine how corporate bonds are analyzed differently now.

Since the bottom of corporate bond market in the 2002, corporations have enjoyed stronger profits and free cash flow. Many corporations have deleveraged. This would be reason alone for corporate spreads to tighten. But there is another factor at play here that is less known outside of the corporate market.

Two Methods of Analysis

There are two distinctly different ways to analyze corporate bonds. The first way is the old standard, which relies on fundamental analysis of a company's financial statements. The second way relies on contingent claims theory (options theory, Merton's model) and primarily uses market-oriented variables like stock prices and option volatility.

The basic idea behind the latter method is that the unsecured debt of a firm can be viewed as having sold a put option to the equity owners. In an insolvency, the most the equity owners can lose is their investment. The unsecured bondholders (in a simple two-asset-class capital structure) are the new "de facto" equity holders of the firm. That equity interest is most often worth far less than the original debt. Recoveries are usually 40% or so of the original principal.

Under contingent claims theory, spreads should narrow when equity prices rise, and when implied volatility of equity options falls. Both of these make the implied put option of the equity holders less valuable. Equity holders do not want to give the bondholders a firm that is worth more, or more stable.

So what's the point? Over the last seven years, more and more managers of corporate credit risk use contingent claims models. Some use them exclusively; others use them in tandem with traditional models. They have a big enough influence on the corporate bond market that they often drive the level of spreads.